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By Luigi Zingales

A Capitalism for the People: Recapturing the Lost Genius of American Prosperity

Eye on the News

Luigi Zingales
Getting the TARP Tax Wrong
The tax is neither fair nor useful.
25 January 2010

President Obama is right to say that taxpayers should be reimbursed for the cost of the Troubled Asset Relief Program. He’s also right to try to extract that cost from TARP’s major beneficiaries. A well-designed tax would be not only fair, but also could reduce, at least to some extent, the moral-hazard problem engendered by every rescue—that is, that government bailouts, by eliminating the negative consequences of perverse behavior, sow the seeds of the next crisis.

But Obama is wrong in both his target and his method. To begin with, the major direct beneficiary of TARP is, contrary to common belief, not the banking sector but the automotive sector, especially the auto unions. While $245 billion in TARP funds have been invested in the banking sector, a good deal more than the auto sector’s $85 billion, the terms of the two investments are dramatically different. In the banking sector, the funds have been deployed with conditions not too far removed from market ones. As a result, the government estimates that taxpayers will actually make a profit from the intervention.

In the auto sector, however, the taxpayers’ “investment” looks more like an out-and-out subsidy. In exchange for the $50 billion invested in General Motors ($30 billion of which is secured), the government received only a debt claim for $6.7 billion, preferred equity for $6.5 billion, and 60 percent of the equity in the new GM. The government subsidy was used to reduce the unions’ loss. With $21 billion of unsecured claims, the UAW received proportionately more: $2.5 billion in debt, $6.5 billion in preferred equity, and up to 20 percent of common equity. The same can be said for the “investment” in Chrysler.

To add insult to injury, the government’s intervention rewarded one of the main parties responsible for GM’s and Chrysler’s demise. As described by Roger Lowenstein in While America Aged, inflated pension and health-care benefits (well above those that most American workers enjoy) made GM woefully uncompetitive. In defending those benefits strenuously, the unions bet that if GM performed poorly, the taxpayers would foot the bill; and if GM did well, the unions reasoned, they would win big time. This gamble is identical in spirit to the one plaguing the banking sector: excess risk-taking under the assumption that the government will indemnify the losers.

If President Obama is really motivated by fairness and sound economic principles, he should tax the unionized auto employees, by introducing a fee on their extra benefits. This fee would help repay the taxpayers for their contributions; it would also reduce unions’ incentive to retain their perks at great cost to society.

And don’t forget the second-biggest beneficiary of TARP funds (at least if the program works): homeowners. The $50 billion allocated to them is, again, not an investment but a subsidy. Many of these homeowners took excessive risks: they knew that if house prices kept rising they would make a fortune, and they hoped (correctly, as it turned out) that if prices dropped, someone else would foot the bill. This gamble was not only tolerated, but also incentivized by government policy, which subsidizes households who leverage more and provides insurance to those with little or no down payment. President Obama should at a minimum eliminate the tax deductibility of debt in excess of 80 percent of the value of a house and get rid of any subsidy for low down payments.

The president is wrong in his method, too. If he plans to tax finance, he shouldn’t single out the banking industry but instead target the entire financial sector, including hedge funds and mutual funds, because the low-interest-rate policy that reinflated asset prices benefited all the investors in the financial market, not just banks. Furthermore, a fee limited to the largest banks—those with more than $50 billion in assets—would increase rather than reduce moral hazard. By paying the fee, the big banks will feel entitled to government rescue: they’ll think that’s what they’ve paid for. In the future, how could the government let CIT, a $71 billion finance company, go bankrupt (as it did) when the company has paid to be rescued? Finally, while the tax is designed to punish excessive borrowing, the penalty is mild and treats short- and long-term debt identically—even though the systemic consequences of short-term debt are far worse.

If President Obama was instead motivated by the legitimate desire to avoid a repeat of the financial crisis, a much better solution would have been a tax on short-term borrowing (as I discuss here), whose excessive use has greatly contributed to the crisis. An even better approach, though, would be to impose a market-based limit on the leverage of large financial institutions (regardless of their legal nature), as economist Oliver Hart and I have proposed elsewhere.

The financial crisis provided the Obama administration with a unique opportunity to reform the financial industry’s perverse incentives. But 16 months after the peak of the crisis, none of these incentives has been changed. Rather than a comprehensive reform, the new bank fee looks more like a punishment meant to placate public anger. It will strengthen the government’s grip on power—and it will forestall real reform.

Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business and the coauthor of Saving Capitalism from the Capitalists.

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